Seven Questions on Foreclosure-to-Rental Conversions

The Obama administration published a “Request for Information” on Wednesday soliciting ideas to deal with rising volumes of foreclosed properties that federal entities are emptying onto the housing market in growing quantities.

As today’s Journal story notes, the administration is exploring ways to accelerate the housing recovery by moving homes out of the government’s hands and into private hands faster. But it wants to make sure that unloading foreclosures won’t simply saturate markets, dropping prices sharply.

Consequently, the idea of converting foreclosures into rental homes is gaining traction. Here are seven questions:

How do foreclosures affect home prices?

Foreclosures tend to sell for less than traditional homes for a few reasons: banks are more willing to cut prices to sell quickly; the homes sometimes are in shabbier condition and need more repairs; and investors are getting discounts by offering all-cash deals. The upshot is this: the higher the share of homes that sell out of foreclosure, the more prices fall.

Isn’t that just the market taking care of things?

Yes. But the process is painful for housing markets. Here’s how: You agree to pay $200,000 for my house. You are making a 20% down payment and are approved for a $160,000 mortgage. But a vacant, shabbier house down the street just sold for $150,000 to an investor in a foreclosure. When an appraiser tells the bank how much my home is worth, they use that foreclosure as a “comparable” sale and tell the bank that my house is only worth $150,000. Now, to sell my house, I’ll either have to lower my price, or you’ll need to double your down payment, since the bank will only make a $120,000 loan. Often, the buyer will walk.

So why is the government exploring options to rent out foreclosures?

Last quarter, Fannie Mae and Freddie Mac sold 100,000 homes, a record high. They owned twice as many at the end of June, representing about half of all foreclosed homes held by lenders.

But that’s just the tip of the iceberg. There are about 700,000 more loans backed by the firms in some stage of foreclosure, which means that Fannie and Freddie are likely to sell more and more homes. If banks and the government entities dump lots of foreclosures all at once, that could send home prices down and create even bigger losses for the industry. The idea is to create an infrastructure that can recycle some of these homes as rentals over the coming years.

In some neighborhoods, foreclosures are selling like hotcakes. But in others, there isn’t enough demand from traditional buyers, so investors are buying up lots of these foreclosures. They are fixing up some and re-selling them, but they are increasingly holding others off the market as rentals. This makes sense in some markets because home prices are still falling as rents rise. Former owners will still need shelter, and many don’t want to move into apartments. Rental yields are looking more attractive.

So what ideas are on the table?

The administration today isn’t proposing anything. Instead, its soliciting ideas. But most of those could fall broadly into two camps.

Under one, investors or nonprofits would propose buying packages of hundreds or thousands of foreclosed properties in bulk on the condition that they rent them out for some period of time. That approach gets the government out of being in any role as the landlord and is preferred by the Department of Housing and Urban Development, which is taking back more properties as defaults mount on loans backed by the FHA.

Another approach would allow investors to enter joint ventures with Fannie or Freddie to invest in a pool of converted rental homes. A national property management firm would handle the day-to-day landlord responsibilities, just as Fannie and Freddie currently outsource property sales to outside firms. Investors and the government entity would split the costs of rehab and the revenues from renting the homes and eventually selling them. Fannie has already done something like this with its much smaller pool of distressed multifamily apartment assets.

Why not just let investors continue to buy up those homes and rent them out?

That’s the big question here: Are taxpayers and neighborhoods better served by letting Fannie and Freddie take back these homes, fix them up, and sell them the way they’ve been doing for the past two years? Or could the firms limit their losses and stabilize neighborhoods sooner by bringing in private sources of capital to minimize losses in a joint-venture?

What are the drawbacks?

Selling lots of foreclosed homes in bulk could lead to big losses if investors demand big discounts. Executing a joint-venture, meanwhile, could require the firms to enter into new areas of property management where they don’t have as much experience. (Fannie and Freddie already rent out thousands of properties to tenants whose landlords have lost the homes to foreclosure.)

Rental programs could also put the government at the center of unseemly conversions of formerly owner-occupied neighborhoods, especially if landlords scrimp on property maintenance.

After HUD sold thousands of homes to investors in California’s Inland Empire in the early 1990s, “you ended up with major sections of entire neighborhoods that just weren’t being cared for,” says John Husing, an economist in Redlands, Calif. “HUD was the Department of Housing and Urban Disaster.”

How much support is there for something like this?

Over the past month, several members of Congress—from both parties—have pushed for banks and Fannie and Freddie to consider rental options. Bills have been introduced in the House and Senate. Many private investors and housing economists are also warming up to the idea.

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